Will You Receive a Surprise Tax Bill in 2019?


2018 will not go down as a great year in the investment world, as the volatility of the fourth quarter brought stock market losses across all major asset classes. Despite this, many actively managed mutual funds distributed significant taxable capital gains in December. This is the result of significant gains that have been building in these funds since markets turned in 2009 as the economy began recovering from the global financial crisis. For investors already grappling with the reality of seeing significant losses on their year‐end statements, they may be even more shocked by the check they are forced to write to pay their tax bill come April.

So how much in taxable capital gains could an investor expect to pay? Below we selected a group of actively managed mutual funds from among the largest and most widely held funds in various asset classes, to build a sample diversified stock portfolio.

With all stock asset classes down for 2018, this portfolio was down ‐10.55% for the year, declining about $105,500 on a $1 million‐dollar portfolio to start the year. For every $1 million dollars in these same actively managed mutual funds, an investor would have received taxable year‐end capital gains distributions exceeding $69,000.

For those investors with even moderate taxable income, these gains would be subject to a 15% long‐term capital gains rate and would have generated more than $10,000 in additional taxes owed. For those investors with high taxable income, or in compressed tax brackets such as trusts and estates, the impact is even more severe. These same long‐term gains would be taxed at 20% plus an additional 3.8% Net Investment Income Tax, bringing an additional tax bill of over $16,000.

While investors often focus on investment return prior to taxes, we believe your true return is only what you keep. Therefore, depending on the investor’s tax rate, the true return after taxes in 2018 was between ‐11.59% and ‐12.15%.

To make matters worse, this does not include any additional taxable gains that might have been generated by the investor or their advisor through re‐positioning or rebalancing of the portfolio during the year. In addition, these taxable gains drive up an investor’s Adjusted Gross Income (AGI), which can potentially create additional taxes due to the potential phaseout of exemptions, itemized deductions, and certain tax credits. For those investors in retirement, this could also result in paying more taxes on Social Security and paying higher premiums on Medicare coverage.

RTD Tax Management Solutions

While this case study paints a painful picture of what many investors are facing, with proper advice and tax planning these additional taxes could have been mostly, or completely, avoided through the use of tax efficient investments, asset location and tax loss harvesting.

Use of Tax Efficient Investment Vehicles

With the explosion of Exchange Traded Funds (ETFs) over the past 10 to 15 years, investors have another choice for owning a diversified basket of stocks instead of a mutual fund.However, due in part to the underlying construction and in part to being index funds, these ETFs have demonstrated over time the ability to be more tax efficient than their mutual fund counterparts. This makes them an attractive alternative for use in personal taxable accounts as well as trusts and estates.

To illustrate, we constructed a nearly identical portfolio using some of the largest and most widely held ETFs in the same amounts and same asset classes as the actively managed mutual fund portfolio above. This same $1 million‐dollar ETF portfolio had $0 in taxable year‐end capital gain distributions. While over longer periods of time we would expect these portfolios to perform similarly, for 2018, this portfolio also performed better, losing ‐7.66% or about $76,600 on a $1 million‐dollar portfolio value to start the year. Most importantly, the return after taxes is the same as before taxes, resulting in an investor potentially saving between $39,000 and $45,000 in 2018 alone, on every $1 million dollars in stock investments.

Asset Location

While the use of ETFs is an attractive alternative for investors with taxable accounts, for those investors desiring to continue to use actively managed mutual funds, there may still be an opportunity to save on these additional taxes. Since most investors have a combination of both taxable accounts and tax‐deferred or tax‐free accounts like Individual Retirement Accounts (IRAs) or Roth IRAs, a portfolio can be re‐configured to be more tax efficient.

For investors with moderately high to high taxable income, especially for those still working, this strategy could be particularly attractive. By using only tax‐free bond investments in taxable accounts and shifting the actively managed stock mutual funds to an IRA and/or Roth IRA, the investor potentially creates a portfolio free of current taxes, while at the same time maximizing the tax‐deferral potential of their retirement accounts.

Tax Loss Harvesting

Even if an investor only has a taxable account and wanted to use these same actively managed mutual funds, while not tax optimal, 2018 still created an opportunity to potentially avoid these additional taxable year‐end capital gains distributions. If the mutual fund owned by the investor was at a loss or had a gain of less than that of the year‐end distribution, the fund could have been sold prior to the year‐end distribution date. This would have reduced or potentially avoided these additional taxable gains. If the losses exceeded taxable gains, an additional $3,000 deduction to ordinary income could also have been realized, while any remaining losses could be carried forward to offset gains in future tax years for up to the lifetime of the investor.

Interested in Learning More?

Whether an individual, household, trust or estate, if an investor’s investment and tax experience in 2018 is similar to the case study presented above, there is clearly plenty of room for improvement. As illustrated, the greater the wealth involved the more money that is potentially being squandered with each tax year that goes by.

As evidenced by the potential tax savings described in our solutions on this issue alone, the value provided by RTD’s advice could far exceed the management fee as part of a far more comprehensive fiduciary advisory relationship.

If you’d like to learn more about how we remove the uncertainty and anxiety caused by an investor’s financial complexity, and how our approach replaces it with clarity and peace of mind, please contact us!